Monday, October 01, 2007

What is the core for?

Suddenly I have so much to say about the core CPI, in response to the latest attacks by Barry Ritholtz and Daniel Gross. I've already said most of it in comments to a post by Brad DeLong (also note kharris' insightful comments) and one to the original Barry Ritholtz post. I may reproduce some of them in future posts here, but my last (thus far) comment (from the DeLong post) is probably what needs to be said first:

There are really 3 separate questions here:

(1) What is the best measure of retrospective changes in purchasing power?

(2) What is the best indicator of the general trend in prices (with respect to what can expected in the immediate future)?

(3) What is the best target for monetary policy?

For the first question, obviously the full index is better than the core, and nobody denies that.

For the second question, there is room for debate, but if the only choices are the core and the full index (to measure inflation for a specific period of a year or less), I would still choose the core. (If you let me smooth the inflation rate with, say, an exponential smoother, I might prefer the full index.)

For the third question, I think there is little room for reasonable debate: the core is better. When food and energy prices go up relative to other prices, the optimal policy rule would accommodate those increases so as to allow other prices to remain stable. The increase in the general inflation rate does little harm; the alternative of deflation in the non-core component would do considerable harm.

Messrs. Ritholtz and Gross, and their supporters in this commentary, are finessing the issue by not distinguishing among these three purposes.

The answer to the third question only works if people know roughly what to expect in advance. If people expect the Fed to control the overall inflation rate but the Fed only attempts to control the core, the outcome will not be good when the two start to diverge. People who attack the core index are contributing to the likelihood of such a bad outcome, as well as to the likelihood of the other bad outcome in which the Fed actually does control the full inflation rate even in situations where it shouldn't.

24 Comments:

Anonymous said...

knzn, These couple of posts seem to indicate that the practice of using core PCE based on transitory energy prices is flawed. Your comments?http://macroblog.typepad.com/macroblog/2007/07/better-not-best.htmlhttp://macroblog.typepad.com/macroblog/2007/07/better-not-best.html

I prefer a different set of questions. These of course generate a different set of answers.

My questions:

1) What is the actual rate of inflation?

2) Why does the BLS model (the official inflation rate) vary so greatly from the real world experience?

3) What are the Fed policy repercussions of the spread between the two?

4) What does this mean to consumers? Investors? Savers?

I am not surprised that traditional economists have circled the wagons around my attack on the credibility of BLS and the Fed. Thats what all Guilds do when they sense a challenge to their authority . . .

(1) What is the best measure of retrospective changes in purchasing power?

the measure should be the supply of the purchasing unit. the greater the supply of that unit, the less it purchases.

MV=PT (2) What is the best indicator of the general trend in prices (with respect to what can expected in the immediate future)?

i think focusing on prices is wrong. inflation has nothing to do with prices; it's purely monetary.

also, prices CAN fall during inflationary periods. real estate is falling now, but commodities are soaring.

(3) What is the best target for monetary policy?

i think the best thing to do is let the market determine monetary policy & interest rates. it determines everything else, so i don't understand why we need to tinker with it when we let the free market determine everything else.

we should only mess around with this only in times of crisis; a recession isn't a crisis, btw.

RB, I was thinking more in terms of the CPI, but I took a look at the Khettry & Mester paper mentioned in the footnote of your second cite. The research still seems too preliminary to draw definite conclusions. They appear to use a forecasting equation with two fitted coefficients, so if we take their results at face value, they still don't necessarily imply that the raw PCE deflator (without the coefficients) is a better predictor than the raw core PCE deflator. I would also bear the Lucas critique in mind here: the relative efficacy of different predictors depends in part on expectations with respect to the policy regime. For example, if the Fed is seen as targeting the raw index but the numerical target is unknown, then predictability can be partly a self-fulfilling prophecy.

I am beating a dead horse here, but let's see what Jean-Claude Trichet, President of the ECB, had to say on this very subject (of core inflation) today:

Risks to the outlook for price developments remain on the upside. They continue to include the possibility of further increases in the prices of oil and agricultural products as well as additional increases in administered prices and indirect taxes beyond those announced thus far. Taking into account the existence of capacity constraints, the favourable momentum of real GDP growth observed over the past few quarters and the positive signs from labour markets, stronger than currently expected wage developments may occur, and an increase in the pricing power in market segments with low competition could materialise. Such developments would pose upward risks to price stability. It is therefore crucial that all parties concerned meet their responsibilities.

The monetary analysis confirms the prevailing upside risks to price stability at medium to longer-term horizons. A broad assessment of the monetary data supports the view that the underlying rate of money and credit growth remains strong. However, the August annual growth rate of close to 12% in the monetary aggregate M3 as well as the annual growth rate of loans to non-financial corporations, which reached a record level of more than 14% in August, may have been influenced by a number of temporary or special factors, such as the flattening of the yield curve and the recent financial market volatility, and may therefore overstate the underlying rate of money and credit expansion.